New European regulations mask benefits of structured productsMay 16, 2016 - 12:42
As far back as 2012 the Financial Conduct Authority (FCA) required that structured products were tested to see that they were
suitable and appropriate. What this meant in practice was to check that the
risk profile of the product was in line with the attitude to risk of advised
clients. Managers of discretionary portfolios were meant to be able to show
that the product complemented the risk profile that they were offering. In
reality this requirement was largely ignored and life carried on as before. The
FCA then reiterated their requirements in the Thematic Review in 2015. This
second paper caused issuers and manufacturers of retail products to take more
notice, and sadly for many the response to this inflation of regulatory risk
has been to curtail or reduce their use of structured products.
The FCA has never been
prescriptive about what stress testing meant, but only required that the
process should be subject to appropriate checks. The European Union have
inevitably gone a stage further and in their new Regulatory Technical Standard,
or RTS, they require that every retail product or packaged retail investment and insurance-based investment product (PRIIP) has a KID, or Key
Information Document. This KID will include information about the expected risk
and return of the product. The RTS is very prescriptive and describes in detail
how the input to the stress testing process has to be calculated, and how the
results of this process have to be used to calculate risk and return.
What are PRIIPS and who does this regulation
The link below is from
the FCA site and offers some clarity about what a PRIIP is and who this
regulation applies to.
It is clear from this
that structured products are PRIIPS if they are made available to retail
investors and that these regulations apply to fund managers, discretionary fund
managers and stockbrokers. Although it is not explicit and there may be some
room for debate, in our opinion the rules apply to structured products bought
by discretionary managers for retail clients.
When will this apply?
The New European Rules are now set, and will
have to be applied from January 2017.
Who has to generate the KID?
This is an interesting
question, the responsibility to generate the KID falls on the product
manufacturer, but it is not always clear who is the “manufacturer”. In most
cases for structured products in Europe ex UK this is the issuer. However, in
the UK the position is more nuanced. The FCA has given specific
responsibilities to the product manufacturer relating to the design, testing,
targeting and distribution of structured products. It is possible that the
issuers of products will assume this responsibility, but that implies a more
invasive relationship with advisers and managers.
The reality at the
moment is that most issuers would like to duck the responsibility of being the
“manufacturer” and claim that they are simply an issuer. For issuers there
is both a fiscal cost from having to generate KIDs and a regulatory cost as
well. If issuers pick up responsibility for the KID, do they also pick up the
other responsibilities of being the product manufacturer?
In our view investment
managers and advisers that specify their own product terms and then getting
quotes from one or more issuers are clearly assuming product manufacturing
responsibility. It is possible that issuer and investment manager are both
responsible, we have already heard lawyers talk about co-manufacturing.
We think that issuers and wealth managers will
both look to each other to comply with this regulation and assume that the
other will pick up the tab. Most issuers are simply not set up to do the stress
testing as prescribed by the RTS. They do not have the processes and procedures
in place to comply with the other requirements that the FCA imposes on the product
manufacturer. Investment managers on the other hand are prevented from
receiving any fee from the product by the RDR rules, and so may argue that they
should not have to shoulder the burden and responsibility and costs that the
new regulations impose on the “manufacturer”.
The problem is
exacerbated by the lack of any grandfathering of existing product. We
understand that the JAC have written to the EU for clarification on this issue,
and that the response has been that KIDS have to be generated on existing
What is the PRIIPS stress testing process?
Broadly products are
tested using a “bootstrap” process. This involves testing the product based on
new hypothetical index series calculated. The new index returns are calculated using
the distribution of daily returns from the last five years.
The output from the
stress test are then used to calculate the volatility of returns and the
expected return. The volatility of returns is based on the loss that an
investor may suffer, and the expected return is an IRR calculation.
The testing process is
not just a one-off, at-issue test. There is a requirement to test products over
time. The minimum frequency is once a year, but in reality the requirement to
update a KID if the risk bucket changes, or if the expected return changes
materially means that most products will have to be regularly re-tested.
The good news here is
that there is a clear and obvious overlap between the new European standards
and the requirements that the FCA have imposed on product manufacturers. The
analysis required to calculate the risk and return for the KID should be
sufficient for the FCA as well.
Is the new KID analysis any good?
We think that there is
much to applaud in what the EU now requires. They have defined a process that
can be used to test a huge range of products which then allows an
apples-with-apples comparison across a number of different axis. In particular
they have described a way to calculate the risk and return of structured
products that allows them to be compared with funds and other assets.
think that some of the choices made by the regulator will minimise the benefits
that structured products offer.
- The way
that volatility is calculated in particular, means that defensive products with
soft protection will appear to be much riskier using the new process.
the observation window used to collect data for the stress test will generate
some strange results where short term performance becomes extrapolated to be a
long term trend.
the risk buckets are very wide, and probably less granular than most attitude
to risk scales. Risk bucket 3 includes products where the volatility is between
5% and 12%. 4 goes from 12% to 20% and 5 starts at 20% and extends to 30%. This
could match to the old low / medium / high classification, but they seem a bit
clunky in today’s environment if there is no decimal point.
What are our early conclusions?
We are still waiting
on some clarification from the regulator on a number of issues, and will
reflect the new requirements in the analysis that we provide. In the mean time
we have come to some initial conclusions.
comparisons: the RTS illustrates how the risk and return from structured
products can be compared to other investments. We anticipate that this will
encourage the use of quantitative analysis to support the use of structured
products in client portfolios because structured products can be shown to
expand the efficient frontier.
ratings: an official risk rating mitigates the regulatory risk that causes many
managers and advisers to avoid using structured products. Now that there is an
official risk rating process for structured products we anticipate that more
managers and advisers will consider using these assets.
analysis: the regulations describe a process for calculating risk and return,
and also the specific parameters that should be used. We anticipate that the
market will build on the foundations that these regulations provide, and
develop processes and parameters that are expected to give better results.
manufacturing: we anticipate that there will be demand from discretionary
managers for companies that can assume responsibility for product manufacturing
that sit between issuers and investment managers. Companies like Cube can take
on the FCA manufacturing requirements, and offer KIDs on the products we
Overlapping responsibility: the EU demand that the manufacturer creates the
KID, the FCA requires that the manufacturer creates products that meet investor
demand, both impose an on-going responsibility to monitor products. We would
expect managers to demand more quantitative research and analysis.
New product shapes: it seems inevitable that manufacturers will look
to develop products that maximise return and minimise risk using the new
process. For low risk investors we expect that low European barriers will give
way to products that offer partial capital protection.
David has been involved in equity derivatives, equity structuring and the structured product market for over 25 years. Before setting up CUBE in 2013 David worked at J.P. Morgan, Barclays and RBS. David has worked with and for retail product providers, discretionary managers and institutional investors.